Student loan defaults could be trouble

Sunday

Jan 26, 2014 at 6:00 AM

By Peter S. Cohan WALL & MAIN

If you want to destroy the global economy, there is nothing better than creating a Wall Street machine that lends money to people who can't pay it back, bundle those loans into securities and then sell them to investors around the world.

The benefit of such a machine is obvious — to Wall Street. After all, the fees for creating and selling these bundles of soon-to-be-worthless loans are big. And when the house of cards collapses, Wall Street institutions are too big to fail, so taxpayers will bail them out.

If this litany sounds familiar, it should. After all, the 2008 financial crisis was caused by lending money to people who could not pay back their loans on houses that they could not afford. Wall Street bundled those mortgages — dubbed subprime — and sold them to investors around the world.

Ratings agencies, competing for lucrative fees, rated the bundles AAA, which made them safe for pension funds and endowments — even though the mortgage holders could not make their payments. That did not matter, though — until the global economy froze up.

Surely, you might be thinking, we have learned our lesson and we will never let such a thing happen again. And just as surely, reality is rearing its ugly head to the contrary. How so?

Consider student loans. There are about $1 trillion worth out there in the hands of students. And given the high unemployment rate and the low salaries that all but the smartest minority of those students can earn — even if they do find a job after graduation — many students can't pay back the loans.

That is especially true for graduates of so-called for-profit educators that get 90 percent of the loans from the U.S. government, and must find the other 10 percent from private sources. The United States government is the largest lender to students.

"In 2012, it provided 73 percent of the $236.7 billion in total student aid offered that year, up from 67 percent a decade earlier," according to The New York Times.

If there is any good news for the U.S. economy, it is that private companies are not making as many of the student loans as they used to. Private-sector loans have fallen 70 percent since 2008 from $22.9 billion to $6.4 billion in 2013 "as investors retreated from the market," noted the Times.

While the odds of a student not being able to repay his loans are high, the private sector lenders in the for-profit education market suffer much higher default rates. According to the Department of Education, 14.7 percent of federal student loans default three years after starting repayment. But the default odds for one for-profit educator, ITT Education Services, are many times higher.

As private investors have withdrawn from the student loan market, it became much harder for ITT to maintain the 10 percent proportion of loans. To meet that standard, ITT started the Peaks Private Student Loan Program, which raised $300 million to increase the amount of private money available for its students.

The bad news is that ITT alumni — who take on more debt and get lower salaries — are less able to repay. More specifically, ITT projected in its most recent quarterly filing that the default rates in Peaks and a similar pool of loans could hit a whopping 59 percent.

The good news is that the total amount of private student loans is tiny relative to the size of the U.S. economy. According to the federal Consumer Financial Protection Bureau, private loans totaled about $150 billion nationally in 2013. The CFPB noted that "more than 850,000 individual loans totaling at least $8 billion are in default." The total private student loans are roughly 1 percent of U.S. GDP and even if all the loans defaulted, the impact would not sink the economy.

Moreover, the amount of packaging and selling of those loans to private investors — known as securitization — has tumbled since the financial crisis. And according to USA Today, securitization of student loans "has withered since the financial crisis as their investment value has plunged."

The bad news is that there will be plenty of individuals who will not be able to repay their student loans and that failure will follow them around for the rest of their lives. The good news is that since private investors withdrew from the market after the financial crisis, the effect of these individual defaults will not be as catastrophic as the subprime mortgage-backed security defaults were.

Nevertheless, the problems that ITT faces are a reminder that we must remain vigilant against allowing Wall Street to resume luring of investors into the inevitably disastrous practice of securitization. While it makes money for Wall Street in good times and bad, it sticks taxpayers and those foolish enough to borrow more than they can repay with a price that is too high for society to bear.